The upside of a down market

Five ideas to help take advantage of falling stock prices.

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For investors, a market pullback can be a painful thing—no one likes to see the value of his or her account go down. But every downturn comes with potential opportunities. One upside: While the stocks and stock mutual funds you hold may be dropping in value, the investments you may want to buy could be getting cheaper. Also, there are certain transactions that get more appealing when market prices fall.

As anyone who has been following the market knows, it is impossible to predict how long a market trend will last, whether prices are rising or falling. “Emotions run particularly high when markets fall, but savvy investors learn to rise above their fears and seize the opportunities that arise,” says Ann Dowd, CFP® and vice president at Fidelity.

Here are five strategies to help you find some upside in a down market.

1. Stay disciplined to seize opportunities.

Investors have a tendency to try to time the market in an attempt to avoid downturns and capture gains—but not very successfully. History shows that, in aggregate, investors often buy into markets near peaks and sell near bottoms—for examples there were big inflows into stocks in 2000 and 2007, just before market peaks, and dramatic outflows in 2008 and 2009, right before the market took off (see chart).

Independent research firm Dalbar estimates that the average equity investor has trailed the performance of the market by more than 4% annually for the past 20 years, in part due to poor market-timing decisions.

Instead of trying to jump in and out of the market, reality-check your investment mix to be sure it is still right for your goals and risk tolerance. If that’s the case, make sure you continue to save and invest. Consider a dollar-cost-averaging strategy, putting a set dollar amount into your portfolio each month. While dollar-cost-averaging won’t insulate you from losses, or guarantee a profit, in a volatile market, you will purchase more shares when prices are lower, and fewer when they are higher. But for dollar-cost-averaging to be effective, you must continue to make investments in both up and down markets.

Read Viewpoints: “Six strategies for volatile markets.”

2. Consider rebalancing.

You may also want to rebalance. Assuming you’re comfortable with your investment plan, check to see if your asset mix may have veered off course due to the recent market pullback. If so, consider rebalancing to your original target mix. That way you are effectively forcing yourself to buy while prices are declining.

Consider a quick example. Say you rebalance annually. Since last summer, the large-cap portion of your portfolio may have declined, and small caps probably lost even more, while bonds may have produced positive returns. Your instinct may be to buy more bonds and avoid those losers, but buying the losers is precisely what rebalancing means: buying more small and large caps—either by reallocating your investments or putting new money to work.

“The beauty of rebalancing and dollar cost averaging is that it helps you buy low—when investments are effectively on sale, countering our natural tendency to do just the opposite,” says Dowd. “Over time, that discipline can pay off.”

Read Viewpoints: “The pro's guide to diversification.”

3. Book losses while you have them.

Down markets also provide an opportunity to boost after-tax returns by booking capital losses. This strategy, called tax-loss harvesting, involves selling stocks, bonds, and funds that have lost value to help reduce taxes on  realized capital gains from winning investments. Don’t have enough capital gains this year? You can use realized capital losses to offset up to $3,000 of ordinary income each year, and carry over unused losses to future years.

How would you use this opportunity without throwing off your investment strategy?

Consider selling investments that no longer fit your strategy, or ones with poor prospects, which you may want to sell regardless of the tax impact. Or, you could look for investments to sell that can be replaced by similar investments, keeping your overall investment mix on track. But be careful: To qualify for the tax loss benefit, you need to purchase an asset that is not “substantially identical” (as defined by the IRS). Remember, tax rules are complex, and you should get more details or talk to a financial planning or tax professional for more information:

“You don’t want to let taxes drive your investing decisions, but downturns do provide the potential to record losses, and reduce your tax bill,” says Dowd.

Read Viewpoints: “Five steps to help manage taxes on investment gains.”

4. Consider a Roth conversion.

Roth IRAs have several benefits, including the potential for tax-free withdrawals,* and no required minimum distributions during the lifetime of the original account owner. To qualify to make a contribution, you must have earned income, and stay under an income limit.

In 2016, if you are married and filing jointly, you must have modified adjusted gross income (MAGI) under $184,000 to contribute up to the limit of $5,500 ($6,500 for those 50 or older). For single filers, your MAGI must be $117,000 or less to qualify for the full contribution. Joint filers with MAGI between $184,000-$194,000 ($117,000-$132,000 for singles) are eligible to make reduced contributions.

Don’t meet those income requirements? Not to worry. Anyone can convert all or part of a traditional IRA to a Roth as long as he or she pays income taxes on the money at the time of the conversion. And a market downturn may be a particularly good time to consider a conversion, because the taxation would likely apply to a smaller conversion amount.

You may want to convert a certain dollar amount, in which case a downturn would let you move more shares. Consider this hypothetical scenario. A couple is married and files jointly and wants to convert as much of their assets as possible to a Roth, while keep their taxable income under the top of the 15% tax bracket. That tax bracket is capped at $74,900 for 2016. After calculating their taxable income from all other sources, they convert enough from a traditional IRA to hit that limit.

Let’s say their taxable income before converting is $69,900, so they can afford to convert $5,000 and remain in the 15% bracket in 2016. Now suppose that before a market downturn the shares of mutual fund A, held in their traditional IRA, are $10 each. If they convert then, their $5,000 conversion would allow them to move 500 shares into their Roth IRA. But if, after a market downturn, those shares had fallen to $8 each, the same $5,000 conversion would allow them to move 625 shares instead. If the shares then returned to $10 each, they will in effect end up with $6,250 moved into the Roth account—even though they only had to pay tax on $5,000.

By converting when the market is down, they may be able to move more shares from traditional accounts into the Roth. Roth conversions are complicated, so consult a professional and seek more information.

Read Viewpoints: “Answers to common Roth conversion questions.”

5. Recharacterize a Roth.

What if you recently executed a Roth conversion and then your investments lost value? Or you are considering converting, but don’t want to pay taxes on an investment that may continue to lose value. Well, you aren’t stuck. A Roth conversion recharacterization can help you undo the change, letting you revalue the conversion at a lower asset level.

The recharacterization would need to be completed by the last date, including extensions, for filing or refiling your prior-year tax return, which typically is on or about October 15 in the year after your conversion. You can generally recharacterize all or a portion of what you converted. And if you change your mind again, assets that you recharacterize to a traditional IRA can be reconverted back to a Roth IRA in the next tax year after the conversion or 30 days after the recharacterization, whichever is later.

Let’s look at a hypothetical $50,000 conversion. Say the downturn reduced the value of the investments to $35,000. Undoing the conversion and then redoing it has the potential to reduce your taxes significantly—by $3,750.

Undoing a conversion may lower tax cost
March 1 of year 1 August 1 of year 2 September 1 of year 2 Net tax savings
Conversion of traditional IRA to Roth IRA Recharacterization Reconversion
Market value $50,000 –$50,000 $35,000
Tax rate -25% 25% 25%
Tax liability $12,500 –$12,500 $8,750 $3,750
The hypothetical is intended to serve as an illustration and should not be construed as tax or investment advice. Your circumstances are unique, therefore if you believe that you need personalized tax advice, you should consult a tax advisor.

Read Viewpoints: "How to reverse a Roth IRA conversion.”

The bottom line

An investment strategy is meant to work over the long term through market ups and downs, so you need to keep a short-term pullback in perspective.

Markets will rise and markets will fall, and with the changes, opportunities will appear. To make the most of a bad market, consider taking advantage of lower-cost investments through a disciplined strategy, while looking for the potential tax benefits of a downturn.

Learn more

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Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author(s) and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
*A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, make a qualified first-time home purchase, become disabled, or die.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
Past performance is no guarantee of future results.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
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The S&P 500 Index is an unmanaged market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
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